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Thursday, August 25, 2011

Understanding Irregular Economics

Paul Krugman has written a post that encapsulates his thinking on macroeconomics - how he thinks other people do it, and how he thinks it should be done. His post is a comment on Barro's WSJ article that I discussed here.

Let's take this apart. First paragraph:

As Glasner says, there’s something deeply weird about asking “where’s the market failure?” in the face of massive unemployment, huge unused capacity, an economy producing less than it did three and a half years ago despite population growth and advancing technology. Of course there’s some kind of market failure, which means that there’s nothing at all odd about asserting that better policy can yield free lunches.

We cannot observe a market failure. To deduce that a market failure exists, one needs a model. Given that we cannot observe market failure by looking at the state of the economy, we also can't say what a "better policy" is. Again, for that we need a model.

Second paragraph:

More generally, the existence of business cycles is hardly a trivial feature of real economies. You can try to explain those cycles in terms of “regular economics” — that’s what real business cycle theory is all about — but that effort has been a dismal failure, even if the practitioners refuse to admit it. The desperate efforts to find something Obama has done that explains why the economy plunged are in effect a demonstration of the hollowness of that whole approach.

Yes, real business cycle theory uses regular economics. But so does all of modern Keynesian theory. The people who worked on coordination failures - Bryant, Diamond, Cooper, Farmer, Benhabib - all used regular economics. So do the New Keynesians - Woodford, Gali, Gertler, etc. Krugman himself uses regular economics. But what was the "dismal failure" of real business cycle theory? Kydland and Prescott introduced a quantitative methodology that is still in wide use. The basic theoretical framework (due as much to Solow, Cass, Koopmans, Brock and Mirman, as to Kydland and Prescott) was expanded upon and used widely in the study of optimal taxation, time consistency, and other things. Further, Woodford adapted it to produce New Keynesian theory. Seems there is plenty of success in there.

Third paragraph:

But I want to add something more: why, exactly, are we supposed to have such faith in “regular economics”? What is the compelling evidence that the vision of a competitive, efficient economy allocating resources to the right uses is actually a good description of the world we live in?

Regular economics is not restricted to the study of competitive and efficient economies. Much of modern macroeconomics deals with externalities and the distortions caused by taxation and information frictions, among other things. The study of efficient economies is only a tiny part of what macroeconomists actually do.

Fourth paragraph:

I mean, it’s a lovely model, and one I, like everyone else in economics, use a lot. But I would not have said that it’s a model backed by lots of evidence. We do know that demand curves generally slope down; it’s a lot harder to give good examples of supply curves that slope up (as a textbook author, believe me, I’ve looked); and it’s a very long way from there to the vision of Pareto efficiency and all that which Barro wants us to take as the true economics. Realistically, imperfect competition, market failure, and more are everywhere.

1. "It's a lovely model" clearly means basic RBC, e.g. Kydland and Prescott. Why the focus on this particular model? Even if we focus on that model in particular, you can't say it's not backed by evidence. That was the whole idea. Go back and read Kydland and Prescott.
2. "it’s a very long way from there to the vision of Pareto efficiency and all that which Barro wants us to take as the true economics." Where does Barro say in his piece that everything is Pareto efficient?
3. Yes, we can find plenty of imperfect competition, market failure, and more. But regular economics can and does deal with all of that stuff. What is the problem here?

Fifth paragraph:

Meanwhile, there’s actually a lot of evidence for a broadly Keynesian view of the world. Not, to be fair, for fiscal policy, mainly because clean fiscal experiments are rare. But there’s huge evidence for sticky prices, lots of evidence that monetary shocks have real effects — and it’s hard to produce a coherent model in which that’s true that doesn’t also leave room for fiscal policy.

We have a fairly good characterization now of how prices behave - the frequency of price changes for particular goods and services. That evidence does not entirely square with modern Keynesian models, and we have search models which can deliver the features of price behavior we observe, but where money is in fact neutral. It does not follow obviously from the observed behavior of prices that the short run non-neutralities of money actually result from the pricing behavior of firms. The big gap in Keynesian theory is that it does not deliver on the elements that are key to how it works: Why are contracts set in nominal terms? Why are prices changed infrequently for some goods and services? What would make a firm unwilling to change its price but more than willing to incur the costs of changing output and employment?

Last paragraph:

In short, there’s no reason at all to consider microeconomics the “real” economics and macroeconomics some kind of flaky impostor. Yes, micro is a lot more rigorous — but if it’s rigorously wrong, who cares?

Note how he uses "macroeconomics." He means the macroeconomics that is spooned out to poor unsuspecting undergraduates in many undergraduate principles and intermediate macro books, which is indeed flaky. This is not the macroeconomics of most practicing macroeconomic researchers, the macroeconomics taught in PhD programs or the macroeconomics of the economists who advise many policymakers. It's not too much to expect that macroeconomists be rigorous - just like everyone else.

13 comments:

On "market failure": Anything less than utopia can be perceived as "failure". Anything that is imperfect has imperfections.

It is one thing to notice the imperfections and correctly describe them.

It is completely another thing to prescribe measures that attempt to correct the imperfections.

Being able to successfully do the former does not provide one with the necessary techniques for doing the latter.

Causes of imperfections are very difficult if not impossible to isolate.

Even if one knows the cause, to try to change the cause is likely, in a complex system, to have unintended consequences that may create imperfections worse than those one is attempting to remove.

A knowledge of complexity theory is important, because this teaches about the sensitivity of complex systems to change. Even the minutest of changes can cause dramatic and unpredictable large-scale effects. I suspect that very few economists have studied complexity theory. If they did they would probably be less confident of their ability to fix the imperfections.

A utopia is simply not possible. Some imperfections are best accepted. Whenever we do not respect the sheer functional power of emergent behaviors, and believe that we can do better, we run a huge risk of suppressing the emergent behaviors.

I don't think this risk is properly acknowledged or understood by many who propose intervention in market economies.

Paul Andrews says few economists have studied complexity theory. I wonder if Prof W can shed some light on this. Why dont we see more of this approach in econ ? Hayek springs to mind as one economist who believed that the macro economy was far too complex to be successfully modeled mathematically.

Another field in which people intervene in complex systems is the field of medicine.

This is a hugely successful field.

If we can successfully intervene and fix imperfections in the human body, how is economics any different?

The answer is that medicine was able to learn through trial and error. Each treatment was tested on many similar cases. Many of these treatments failed, because of the difficulties inherent to intervention in complex systems.

In economics, we only have a few cases, and each has much more difference to the other cases than one human body has to another.

We can't afford for the economy to die in order to try particular treatments.

Imagine where medicine would be if it had only one human, and a few live animals of different species, and a few dead bodies of other species, to practice on, and the human had to be kept alive at all costs.

This is analagous to where economics is, and always will be, and we should be wary of all interventions lest we kill the host.

I am not sure getting some benefit (either as a practical approach or only idea) from the complexity theory helps us fix imperfections in the economy. First, what do we mean by imperfection? I am not a medical doctor, yet fixing imperfections in human body shouln't be a big problem as long as you know how the related body part should function perfectly. A doctor has good knowledge on the "true" structure of the body. To me, finding a bettet cure and remedy for economic problems is beyond the use more technical approaches. Sometime ago, correct me if I am wrong but chaos theory was quite popular at least in finance. I am not sure how well it still contributes nowadays (I am not a chaos fun anyway). Using similar (even identical) approaches in different fields may not necessarily bring advantages all the time. Besides, we have game theory. It helps us understand interactions, resolve conflicts among agents and solve market problems (e.g. kidney market). We already have many tools in econ. Maybe we need more intuition and knowledge to properly guess how economy functions.

Regarding your "taking apart" of the first paragraph, I'd suggest giving your "Where's your model?" mantra a rest. Insisting Krugman present a full model in a blog post intended for a general audience just makes you look out of touch.

That was... probably the most respectful I have ever (ever, ever) seen Paul Krugman be when he's wearing his blogger/hack hat. It was almost surreal. And he admitted that there's little evidence in favor of discretionary fiscal stimulus, lord what has the world come to?

Some excellent economists got excited about that in the 1980s in particular. There was a lot of interest in unusual dynamics and multiple equilibrium. This is related to my discussion of coordination failures. There are "sunspot equilibria" where you get aggregate fluctuations driven by extrinsic uncertainty and self-fulfilling beliefs, and models with periodic cycles and chaotic dynamics. Interest in chaos in economics faded away - people just did not find it useful, but Keynesians in particular got quite interested in other types of dynamics.

"Insisting Krugman present a full model in a blog post intended for a general audience just makes you look out of touch."

No, I did not mean to suggest that. I meant what I said, which is that the statement he made is incorrect.

Krugman is a well-educated economist with recognized achievements as an academic, obviously, which means that we should hold him to a high standard. In writing for a lay audience his writing should be factually correct and consistent with standard economic practice. He should support his arguments with sound economic evidence, and make it clear what are his own opinions and which ones are not in fact widely shared in the profession. Often Krugman falls short, and sometimes far short, of the standard, and this post of his is a prime example. A blog limits the economic content you can get across. We don't expect him to work it all out in the post. We just want honesty and truth.

Except he couldn't possibly be any more honest and open about how his views differ from those "widely shared in the profession." His economics-has-run-off-the-rails theme is open and constant. You obviously disagree, but it's not clear to me what your goals are in these Krugman posts. Sometimes it seems you'd like him to engage in an epic Battle of the Models, but this isn't the game he's playing. Other times it appears you'd like to, like him, convince a wider audience to accept your views on macro. If so, "you need a model" just won't cut it; you have to show them in a convincing way how, say, unemployment insurance or a sudden rise of workers being in the wrong place causes unemployment. And pretending not to understand what aggregate demand is also won't cut it for an audience for whom the concept has intuitive appeal. I'd suggest addressing the concept head-on if your goal is to convince people it has no usefulness. But it's your call.

"Except he couldn't possibly be any more honest and open about how his views differ from those "widely shared in the profession.""

He typically mischaracterizes what is done in the rest of the economics profession. He's either aware of what people do, and therefore being dishonest, or he's ignorant. Either way it's bad. Further, he does his best to make the economists he disagrees with look like nasty bad guys.

"Sometimes it seems you'd like him to engage in an epic Battle of the Models, but this isn't the game he's playing."

No. That's actually a big part of his shtick. There's the "one model to rule them all," the notion that we need to go back to macro in the style if Hicksian IS/LM. And from his point of view, the foil is a basic RBC model. That's all very clear.

"you have to show them in a convincing way how, say, unemployment insurance or a sudden rise of workers being in the wrong place causes unemployment."

"And pretending not to understand what aggregate demand is also won't cut it for an audience for whom the concept has intuitive appeal."

That's a big problem. It's very important for people to understand why that language should not be appealing. Some of economics is about showing people how their intuition can be wrong; we don't want to pander to it. Obviously you don't get it yet though, so obviously I'm failing there.

When I say I don't understand what aggregate demand is, I'm not pretending. You can't address the concept head-on because it's not a concept. There is a downward-sloping curve that you see in some undergraduate textbooks, and many generations of textbooks ago, someone had the bright idea to call that thing an "aggregate demand" curve. This is one of the things that we get PhD students exposed to that stuff to un-learn, for various reasons. It's much harder to un-learn this among the general public. For many of them, that's all the macro they have ever seen. I'll keep trying though.

"It's very important for people to understand why that language should not be appealing."

Yes!

Actually I think most people on the street would stare blankly at you if you talked about aggregate demand.

The people that need to understand why the lanuguage should be unappealing are that small fraction, nevertheless large in numbers and loud in voice, who have graduate level "knowledge" of macroeconomics.